Six classic investing mistakes

Successful investing is as much about avoiding costly errors as it is about finding cheap stocks. Here are six of the best ways to go about losing money.

Done well, value investing is a successful, proven, and safe way to invest. The logic of the approach—buying an asset for less than its underlying value—is irrefutable, and the records of those that practice it are convincing (see Warren Buffett’s essay, The Superinvestors of Graham-and-Doddsville).

However, an understanding of the principles of value investing isn’t enough. In investing, mistakes are inevitable, and the key is to learn from them and avoid repeating them. Moreover, we can try and learn vicariously; through the experience of others.

Over the past 12 years, we at the Intelligent Investor have made plenty of mistakes, and have also had more than our fair share of successes. We’ve learnt from both. What follows is your opportunity to do likewise in six key areas.

Key Points

Value investing is successful but mistakes will be made

Six of the most common ones explained

Illustrated with recommendation case studies

1. Focusing only on the numbers

One of the most common investing mistakes, especially for the inexperienced, is to concentrate only on a stock’s financial data. Applying a price-to-earnings ratio, a book value multiple, or a discounted cash flow analysis can provide very precise estimates of value. But that’s not all there is to analysing stocks, as Gareth Brown’s cover story made clear with the return on equity measure (see ROE: Pluses and pitfalls).

The big four banks, for example, all carry forecast dividend yields of about 6% to 7%, and price-to-earnings ratios of around 10 to 12. Looking at the numbers, they’re closely matched.

Big four bank PERs and dividend yields

PER

Dividend yield

Commonwealth

12.6

6.1%

NAB

12.7

6.6%

ANZ

11.9

6.5%

Westpac

10.6

7.1%

When you consider the risks entailed by ANZ’s Asian expansion and NAB’s aggressive push for market share however, suddenly the numbers don’t seem to tell the whole story. These qualitative factors are the reason we favour Commonwealth Bank and Westpac over ANZ and NAB.

So, before looking at the numbers, make sure you truly understand the business that’s generating them.

2. Mistaking permanent declines for temporary ones

In the hunt for value, it’s often necessary to buy stocks with a few fleas. When businesses hit rough patches and earnings temporarily decline, it can be a great time to buy. This strategy led to successful Buy recommendations on Cochlear at $19.04 on 18 Mar 04, and Leighton Holdings at $7.83 on 11 May 04.

We have a positive recommendation on Aristocrat Leisure today for the same reason. While mismanagement, a poor product line-up, the strong Aussie dollar, and cyclical headwinds are all hurting Aristocrat in the short term, we expect this business to perform well in the long run.

The risk is if its current problems aren’t temporary. If Aristocrat’s profits stay permanently depressed, we'd have overpaid for this business, and be guilty of having mistaken Aristocrat’s structural decline for a cyclical one.

3. Buying low quality businesses

Owning high quality businesses over the long run is the key to successful investing. Our Masterclass special report on Warren Buffett details his incredible success employing this approach.

Unfortunately, high quality businesses are seldom cheap. Value investors therefore often end up with portfolios full of cheap but low quality stocks, entailing greater risk, more stress, and higher stock turnover.

In the past, Intelligent Investor also fell into this trap, covering too many small and dubious businesses. But with our new focus on blue chips and wonderful businesses trading at fair prices (see Christmas trimmings: introducing the nifty 50/50), you can now fill your portfolio with high quality businesses, especially if you’re patient and buy opportunistically.

4. Neglecting economic considerations

‘If you spend more than 13 minutes analysing economic and market forecasts, you’ve wasted 10 minutes.’ Ever since uttering that sentence, legendary fund manager Peter Lynch gave value investors a free pass to ignore the economy. Or so they thought.

Lynch’s advice does not mean that you can completely ignore the economy. It means that the success of your investments should never rely on specific, short-term economic forecasts. What’s the difference?

An investment in Rio Tinto, for example, hinges largely on the continued strength of China’s economy and its building and infrastructure boom. That’s an economic forecast we’re not willing to gamble on.

On the other hand, we’re aware that weak global economies and low stock prices are currently depressing Platinum Asset Management’s earnings to less than their long term average. That’s why it’s cheap. We don’t need to know when or why, but it’s a near certainty that stock prices, and Platinum’s profits, will rise eventually. An appreciation of cycles, rather than economic predictions, should underpin your stock purchases and disposals.

5. Ignoring the market

As a value investor, a healthy scepticism of the market’s wisdom is a necessity; whenever you buy something, it should be because you think the market is pricing it incorrectly.

When you’re right, the rewards of ignoring the market can be enormous. As our special report RHG: A value investing case study explains, the market wrote this stock down from $0.95 to $0.05 before our positive recommendations were vindicated.

Horse Sense

‘There are two requirements for success in Wall Street. One, you have to think correctly; and secondly, you have to think independently.’ – Benjamin Graham

But when you’re wrong, it can be a disaster. Backing ourselves over the market explains why we were far too late in pulling the pin on Timbercorp.

Share price movements should never influence your analytical process. But it is necessary to be aware of them; they can offer a timely prompt to reconsider your thinking, as we did recently with our downgrade of Harvey Norman. The market is often right. When you’re going against the grain, make sure you know why you disagree with the market and have good reason for doing so.

6. Mistaking price and value

If you’re aiming to buy stocks for less than their intrinsic value, a lower price can only mean better value, right? Wrong.

Shoptalk

Value trap: A value trap is a stock that has fallen in price and is thus mistakenly believed to be undervalued.

Consider Telstra, which is trading close to its lowest ever price. By that simple logic, it should be more attractive than ever. But the decline of its traditional fixed-line business means it’s just not worth the high of $9.20 it hit more than a decade ago, nor the $4.80 or so it traded at in 2008.

It’s tempting to anchor to previous prices (see How anchoring sets you adrift). But they offer no clue regarding today’s value. The fact that a stock has fallen does not in itself make it cheap; only the difference between its intrinsic value and the price at which it trades does.

Avoiding these classic value investing mistakes will do wonders for your returns. In order to get the most out of this article, use this 6-point checklist to sift out these mistakes in your own portfolio. Moreover, ask yourself: 'Do I own quality stocks? Do I have an understanding of how various economic changes may impact my holdings? Do I own stocks where I don't fully understand its underlying businesses?'

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